A False Remedy

President-elect Joe Biden recently reiterated his commitment to discharging $10,000 of higher-education debt per borrower. At the extreme end of the progressive political spectrum, however, amounts of $50,000 and more are being bandied about.

In other words, unqualified amnesty.

The urgency that is propelling this matter to the forefront is the December 31 expiration of the CARES Act’s student loan forbearances (principal and interest) and the tidal wave of new payment defaults that may well follow.

But the notion of amnesty — whether in full or in part — is a political expedient. An ineffective remedy that does not give sufficient weight to several fundamentally important considerations.

To start, should all student loan borrowers benefit from this largesse?

According to the Federal Reserve Bank of New York’s quarterly report on household debt and credit, more than 20% of all education-related loans that are currently in repayment (which constitute roughly half of all student loans) were 90 or more days past due at the end of the calendar quarter immediately preceding the passage of the CARES Act last March.

Given that delinquency rates are typically measured at 30 or more days past due, it is reasonable to presume that the true rate of payment delinquency is quite a bit higher. Add to that the loans that were temporarily put into forbearance prior to CARES, plus those that have been restructured under the myriad Department of Education income-based repayment plans, and it is not a stretch to estimate that 40% or more of all loans that are currently in repayment are indeed troubled debts.

But that leaves the 50% or 60% of student loan borrowers who appear to have the means to continue making their monthly payment in full and on time. This suggests that extending forgiveness to these debtors is unwarranted.

And then there is the matter of equity: If all those with existing debts are granted amnesty today, shouldn’t all those who have successfully repaid their education-related debts in the past receive a refund?

Second, what effect would amnesty have on taxpayers?

For every dollar the Department of Education lends to higher education learners, it borrows an equal amount to fund that activity. At its September 30, 2019, fiscal year end (the most recently available financial statement at the time of this writing), the department reported $1.12 trillion in Federal Direct loan receivables (the amount due from its borrowers) and $1.19 trillion in corresponding debt (the amount the U.S. Treasury borrowed on its behalf).

Theoretically, one should offset the other as debtors repay their loans, which means that taxpayers would then be held harmless. But loan forgiveness would alter that calculus, with the resultant shortfall added to the burgeoning federal deficit.

Third, what of the lingering consequences?

Consider that the dollar value of debts that are discharged in whole or in part is treated as ordinary income under the tax code. As such, student loan borrowers whose obligations are forgiven will still have an IRS bill to pay.

What’s more, they will also shoulder the longer-lived credit-related implications of their forgiven loans since FICO score algorithms will take these into account and credit bureau reports will also display the record of payment delinquencies that led up to that point.

Last, and perhaps most important, is the damage that will be done to the founding principal of lending.

Credit is, at its core, a function of trust: I will lend you $100 now because I trust that you will pay me back later. That trust is challenged if you pay me back less than what I loaned you and breached if you never pay me back at all.

Certainly, loan losses are a fact of life for lenders. It is a metric that is vigilantly tracked and routinely modeled so that lending institutions can integrate the dollar value of default probability into their loan-pricing matrices.

In other words, they are endeavoring to quantify the net dollar value of trust. As such, loan forgiveness, on a scale that is currently being contemplated, will upend that calculation, resulting in higher rates on future loans, if not the discontinuation of the subject loan product.

A Better Way Forward

The glaring mistake here is that amnesty empties the bucket without repairing the hole in the roof. The underlying problem with the student loan program — as evidenced by a failure rate that is a multiple of all other consumer loan products — is that it was incorrectly structured at the outset.

Consider what the various remediation plans that the Department of Education has put into place for financially distressed borrowers does: it lengthens the duration of their loans — often to twice the original 10-year term — so monthly payments are reduced to a more affordable level, relative to income. Yet, because this is also a cumbersome and confusing process, many borrowers who would otherwise benefit from these plans don’t end up helped as the delinquency statistics affirm.

Rather than nickel-and-diming this trillion-dollar problem by continuing to deal with it on a onesy-twosy basis, the entire portfolio of Federal Direct loans should be restructured so that durations are doubled, whether or not repayment has begun. In other words, what was once a 10-year term should now be lengthened to 20 years, and what is now a 7-year remaining duration should be lengthened to 14 years.

The personal budgetary consequences of this move would be meaningful, particularly for recent college grads.

For example, according to the Department of Education’s Federal Student Aid Portfolio Summary, the average student loan balance is $36,635. At the current 4.53% interest rate for unsubsidized Federal Direct loans, the monthly payment is $380.21 for the standard, 120-month term (10 years).

When that term is lengthened to 240 months (20 years), though, the monthly payment drops by nearly 40% to $232.36 — a $148 difference that could spell the difference between economic self-sufficiency and parental dependency.

The downside, of course, is that the longer the loan duration, the greater the amount of total interest paid over that extended period. That is why Biden’s restructure should also incorporate a fee-free prepayment option for those who can afford to continue remitting higher monthly payments.

Finally, all derogatory credit reporting data for this category of consumer debt should be expunged once the restructure is put into place. Although no one twisted their arms to borrow the money, student debtors should not continue to be punished for the inappropriate loan structure they were forced to accept for an education that few are in a position to pay without assistance.

In sum, taking this approach checks all the boxes:

• Those who do not need the help can elect to forego it without penalty.
• Taxpayers are not unduly burdened because the loans stand a better chance of being repaid in full.
• There are no adverse tax consequences or lingering credit blemishes.
• No moral hazard exists because the government is correcting an error of its own making.

One more thing.

Trees do not grow to the sky. Given the rapidly escalating level of federal indebtedness and despite the self-liquidating characteristic of education loans, the federal government may at some point choose not to continue in the lead lending role for this program.

If so, and only after loans are properly restructured, the department can elect to divest all or part of its portfolio to the private sector. Such a move would result in a dollar-for-dollar reduction in the federal deficit when the proceeds from that sale is used to extinguish the attendant debt.

Financially distressed borrowers would also come out ahead because their newly extended loan durations obviate the need to plead for relief to heretofore frustratingly unresponsive student loan administrators.

The only proviso is that given the uncollateralized nature of these debts, the government’s existing payment guaranty would need to remain in place, just as it has for the discontinued Federal Family Education Loan program that are private-sector owned (of which roughly $246 billion remains outstanding).

Certainly, a reasonable bargain to strike on a materially less risky program.